The Federal Reserve System

Just as Congress and the president control fiscal policy, the Federal Reserve System dominates monetary policy, the control of the supply and cost of money. Since monetary policy affects every
sector of the economy, the Fed has to be considered coequal with the president and Congress in macroeconomic decision making.

The Fed's Structure

The Federal Reserve system consists of a seven-member board of directors in Washington, D.C.,
and 12 regional banks, each controlled by its own directors. These regional institutions, owned by
commercial banks within their jurisdictions, only do business with the Treasury and their member
banks, not with the public at large. They do not lend money for automobiles or homes, and their
main assets are U.S. government securities (such as Treasury bonds). The Federal Reserve banks
also perform a variety of services for other banks such as check processing and storing and
distributing cash. All national and state chartered banks are subject to Federal Reserve
supervision and regulation.

The Federal Reserve Board of Governors oversees the entire system. The president appoints six
of the governors (subject to Senate confirmation) to 14-year terms and the board's chair to a 4-year
term. (The president's and chair's terms of office do not overlap, however.) Alan Greenspan is the
current chair.

The Fed's Operations

Even though the Constitution authorizes the government to "coin money," it would be impractical to
control its supply by speeding up or slowing down the printing presses. After all, if enough were
printed it would soon be worthless. It is also impractical to tie the value of paper money to
precious commodities such as gold or silver, since the supply of these commodities does not
always keep pace with economic growth. Governments discovered that when these metals didn't
keep pace with growth there was usually insufficient currency to finance investment and
consumption. Therefore, the Fed relies on its legal authority to manipulate "fiat money": paper
currency, coins, funds in checking and savings accounts, and other legally accepted forms of
exchange.

The Federal Reserve System manages the money supply in three ways:

Reserve ratios. Banks are required to maintain a certain proportion of their deposits as a
"reserve" against potential withdrawals. By varying this amount, called the reserve ratio, the Fed
controls the quantity of money in circulation. Suppose, for example, it orders banks to hang on to
an extra 1 percent of their deposits. They would then have 1 percent less to lend. One percent may
not sound like a lot, but it translates into billions of dollars that are siphoned out of the economy.

Discount rate. When banks temporarily overcommit themselves, they occasionally have to borrow
from the Fed to secure the necessary funds to meet their reserve requirements. The interest rate
charged for these loans is the discount rate, and it too affects the money supply. If the Fed raises
the discount rate, banks cannot afford to borrow as heavily as before and have to curtail their
lending and raise their own interest rates. That results in less money flowing into the economy.
Conversely, if the Fed relaxes its discount rate, financial institutions have more dollars for their
customers. Seen from this perspective, the discount rate has a snowball effect: Raising it means
that other interest rates go up as well and, other things being equal, economic activity slows down;
lowering it has the opposite effect.

Open-market operations. By far the most important of the Fed's activities are open-market
operations, the buying and selling of government securities. After Congress approves an increase
in the national debt, the Treasury Department prepares a mix of bonds, bills, and notes that it
auctions to private dealers who are authorized to trade government securities. When it wants to
influence economic activity, the Fed buys or sells these assets through its Federal Open Market
Committee (FOMC) or open-market desk, as it is commonly known.

The process works this way: If the Fed decides to increase the money supply, its open-market
manager buys back treasury securities from private dealers, paying for them by simply crediting
their bank accounts. It does not transfer any actual cash. (This power distinguishes it from all other
financial institutions and gives it its clout.) The dealers' banks now have more money to lend, and
these loans ultimately find their way into more banks, which pass a portion of them on to
additional borrowers. The Fed's initial purchase thus has a multiplier effect as money ripples
throughout the economy. Of course, the process is reversed when the Fed sells off some of its
securities, because it in effect deducts the price from the purchasers' accounts, leaving their banks
with fewer deposits.

The main idea is that the Fed's accounting maneuvers, not switching the printing presses on and off,
produce increases or decreases in the money supply.

The Fed and the Political System How one interprets the Fed in relation to various models of
who governs, such as pluralism or the power elite, depends on how much independence from
political influence one thinks the system has. On paper the Federal Reserve System appears to be
relatively autonomous, since it receives its operating revenues from its constituent banks, not from
congressional appropriations, and since its governors, once in office, cannot be dismissed by the
president. The governors' long terms mean that an occupant of the White House cannot expect to
pick a majority of the governors. The Fed, moreover, conducts its meetings in private and is under
no legal obligation to report to the executive branch. Given these conditions, one might think it
could escape public accountability altogether.

Yet the Fed is also the creation of Congress, which takes a strong interest in its work and can
always amend its charter. Furthermore, as a practical matter, the Fed's officers have to interact
daily with senior executives in the Treasury Department, the OMB, and other agencies. The chair
frequently testifies before legislative committees and regularly consults with the president's staff.
All members of the board of governors realize the value of maintaining support at both ends of
Pennsylvania Avenue because they know determined political opposition can undercut their
policies. In short, the Federal Reserve's statutory independence does not immunize it from political
pressures.

The ill-defined boundaries between the Fed and the rest of the Washington establishment leads to
endless debates about its autonomy. Some observers emphasize the Fed's political nature, arguing
that it pays close attention to the desires of the White House. Presidents normally want the money
supply to flow freely enough to keep the economy booming and will pressure the Fed to achieve
that result. Members of the board do not want to antagonize the chief executive and, if pressed,
often cave in.

Some political economists go even further: They detect a political monetary cycle (PMC), during
which the Fed relaxes monetary policy in the months before a presidential or congressional
election, hoping that business will pick up and thus make the incumbent president's party shine in
the eyes of the electorate. As soon as the campaign ends, however, it tightens the screws again to
hold down inflation. According to this interpretation, the Fed rhythmically starts and stops the
economy for partisan purposes. If true, the existence of a PMC would suggest that the Fed is at
least indirectly accountable to the people, as democratic theorists hope.

Others, however, doubt the Fed's susceptibility to presidential influence and question the whole
PMC concept. It seems unlikely, they claim, that the Fed would act so blatantly on anyone's behalf
because such partisan behavior would tarnish its reputation in financial circles for competence and
objectivity. It is also doubtful whether the Fed has sufficient data and knowledge to fine-tune the
supply of money on short notice. Monetarism, in the last analysis, is a broadsword, not a scalpel,
and cannot be wielded with the precision assumed by the PMC hypothesis. Finally, several
empirical studies dispute the existence of a political monetary cycle. One economist said that he
could not uncover a "single episode...in the Fed's history to suggest that [it] had bowed to
presidential election pressures, and a lot of episodes to suggest that it resists them."

If the Federal Reserve System avoids the tugs of partisanship, what factors do affect its actions? It
could be argued that it has many of the trappings of a power elite. In the first place, monetary
policy is by any reasonable standard a trunk decision. The availability of money and magnitude of
interest rates affect employment, prices, savings, investment, growth, and productivity and hence
touch the lives of everyone from the smallest consumer to the largest corporation. These policies
are developed and enforced by the Fed's board of governors and its operating arm, the FOMC, two
tiny, nonelected groups of men and women with close connections to the banking and financial
communities. Indeed, the background of the Fed's highest officers is one of its most distinguishing
features. Though many of them come from modest origins, they have spent the bulk of their careers
in major banks and Wall Street investment firms and many, like former Fed Chairman Paul Volcker
and the present chair, Alan Greenspan, have shuttled back and forth between jobs in these private
financial institutions and important positions in the U.S. government.

Spending one's life in banking, business, and commerce
creates the sorts of loyalties the power
elite school predicts. One expert, who does not necessarily accept the power elite thesis,
nonetheless lends it credibility when he writes that "Federal Reserve officials work in a milieu
that is significantly shaped by the interests and concerns of the commercial banks."

In brief, as much as fiscal policymaking seems
to conform to the pluralist interpretation of
American politics, monetary policy approximates the power elite model. Yet before accepting
either of these theories, we need to see what influence the public as a whole exerts.